For Geithner's "Bad Bank": A Toxic Financial Mutant

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Craig Ruttle / AP

The crisis in the banking industry has been blamed on the boards of directors including those of Bank of America.

A financial milestone was achieved on October 27, 2004 with the birth of Strata 2004-8. If you haven't made arrangements for the five-year anniversary this fall, don't worry. Few people will be celebrating.

Strata is one of the many so-called toxic assets clogging the nation's financial pathways. What's more, the complicated bond and its ilk are likely to present a significant stumbling block in the government's latest effort to fix our ailing banks. (Read "Why Your Bank is Broke.)

On Tuesday, Treasury Secretary Timothy Geithner is expected to announce the administration's plans for the second half of the $700 billion bank bailout approved by Congress last fall. The centerpiece is likely to be a government-backed aggregator bank (the much-discussed "bad bank"), which will provide financing and loss protection for investors willing to buy the troubled assets sitting on bank balance sheets. Those delinquent loans, or the bonds tied to them, are dragging down the financial firms' value, putting some dangerously close to insolvency.

But for the plan to work, private investors and the government will have to agree what these loans are worth. "Many of the institutions that bought these deals didn't understand them fully," says Barry Silbert, chief executive of SecondMarket, which helps investors buy and sell hard to trade assets. "It is going to be very hard for the government to come in and try to pack up these opaque assets and ship them off to investors." (See the top 10 financial collapses of 2008.)

Pricing plain-vanilla mortgage-backed securities (MBS), which are based on thousands of home loans, isn't easy. But MBS are only the tip of the troubled bank iceberg. Lurking below are bonds that are more complicated, and much more difficult to value. Among the most confounding are collateralized debt obligations (CDOs).

It's these bonds that the government's aggregator bank will have to deal with first. In a November survey officers at the nation's largest banks said CDOs were among the assets they would most like to sell should the government begin buying troubled bonds.

Even among CDOs, Strata is more complicated than most. Unlike other bonds, it is not based on loans, but on bets other loans will go bust. Strata and its ilk were called synthetics, and could make up as much as a third of $1.5 trillion in CDOs issued in the past five years.

Before explaining the nuts and bolts of Strata's structure, it may be wise to put down your Blackberry, mute your CNBC program and turn down your iPod. This stuff is very tricky, perhaps far more so than any investment should be. That's part of the problem. (See the worst business deals of 2008.)

Here's how Strata worked: The original investment (made by hedge funds or other big investors) was $20 million, plus a fee paid to the underwriter, Bank of America, for structuring the bond. Bank of America then took the $20 million and bought some liquid, safe asset, such as Treasury bonds. Those safe bonds then became Strata's collateral.

And now comes the messy part. Bank of America used Strata's collateral as the backing against which it could write credit default swaps (CDS), that is, insurance contracts based on whether some other bonds get paid back. As a writer, or seller, of CDS contracts, Strata investors get a regular fee, much like a annual amount any insurance holder would pay, for guaranteeing the buyer of the insurance against losses on the bonds. All told, Bank of America wrote CDS contracts worth $20 million based on the debts of as many as 75 companies. Add the fees from the insurance contracts to the interest Strata was already receiving on its collateral and voila you get an annual yield for the bond of 4.93%, or more than double the actual bonds Strata held.

Here's the catch: If the bonds Strata insured against go bad, Strata is on the hook for the losses. And in a twist on regular insurance, the buyer of a CDS contract [i.e., the insured] doesn't actually have to own the bond. If the bond goes belly up, they get paid as if they had, pocketing the insurance payout as a profit, which of course would be a loss for the owners of Strata.

But wait, there's more. Unlike other CDOs, Strata is a so-called single tranche CDO. Most CDOs own hundreds of millions of dollars of loans. Those loans are pooled together and then various bonds are sold based on the portfolio. But all the bonds are not the same. They are stacked based on risk. The highest tranche bond gets paid its dividends based on the first loan payments that come in the door. Bonds at the bottom of the stack get paid last, which means those investments are wiped out first if borrowers fail to pay back their loans. Those bonds have the highest risk, and the highest yields.

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